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Fed Forms Plan To Make Frozen Assets Liquid

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By NEIL IRWIN, The Washington Post

Published: December 13, 2007

WASHINGTON - The Federal Reserve, in a move Wednesday morning coordinated with central banks in Canada and Europe, announced a new set of steps to try to make banks more willing to lend their cash and help thaw the world's frozen financial system.

In a surprise announcement a day after cutting interest rates to stimulate the U.S. economy, the Fed said it would make $40 billion and perhaps more available to banks through new short-term loans, and also would provide at least $24 billion to European central banks coping with a dollar shortage.

The announcement sent U.S. markets higher, with the Dow Jones industrial average up 124 points just before noon.

"The Fed has not only opened its vault doors to the banking industry, they are now trucking it to their place of business," said Scott Anderson, a senior economist at Wells Fargo, in a written report. "If that doesn't get the banks excited about lending again, nothing will."

Financial Institutions Hoarding Cash

The Fed's action attempts to deal with a difficult problem confronting the world's central banks: Financial institutions globally are so worried about losses from U.S. mortgage securities and other exotic investments that they are hoarding cash, unwilling to lend it to each other except at unusually high premiums.

That is making it more expensive for ordinary businesses and consumers to borrow money, slowing the economy and keeping Fed rate cuts from stimulating the economy as intended. When the Fed cut a key short-term interest rate Tuesday, investors had hoped it also would take action to improve liquidity as well.

To try to counteract cash hoarding by banks worldwide - and thus make the financial system more liquid - the Fed announced a coordinated action with the European Central Bank, the Bank of England, the Bank of Canada and the Swiss National Bank.

As part of the new liquidity measures, the Fed established a temporary "term auction facility," at which it will auction short-term cash to banks against which the banks must offer collateral. It is similar to the Fed's discount window, which banks can use to borrow money at a fixed rate.

Typically, however, banks turn to the discount window for emergency funds only because a stigma is attached to using it. Because the new funds will be offered through auction, there is less likely to be a stigma attached and banks may be more willing to use it.

The first of these special auctions will be Monday, the Fed said in a statement, and $20 billion will be available. A second $20 billion will be auctioned three days later.

The Fed also said it will engage in a temporary swap agreement in which it will provide $20 billion and $4 billion, respectively, to the European Central Bank and the Swiss National Bank. Much of the shortage of dollars in the world has been in Europe, so this appears designed to make sure European banks can acquire the U.S. currency without paying excessive interest rates.

Other measures include steps taken by the Bank of Canada and others to expand the collateral they will allow banks to post for short-term funding.

On The Heels Of Interest Rate Cut

The liquidity steps come a day after the Federal Reserve cut a short-term interest rate to try to keep problems in the housing and mortgage markets from dragging the nation into recession. The stock market tanked on that news, as investors were hoping for more dramatic action - and possibly a move to improve the liquidity environment such as the one announced this morning.

The central bank held off announcing the move so it could take a coordinated action with its counterparts in Europe. "This was a global effort among a number of central banks," said a senior Fed official in a briefing with reporters Wednesday. "We wanted to announce that together. We couldn't have announced that yesterday, as Europe was closed." (At 2:15 p.m., when the Fed announced its interest rate cuts, it was 8:15 p.m. in most of Europe, and financial markets had shut down for the day.)

"We and the other central banks wanted to make this announcement when the affected markets were open," the official said.

The Fed's policymaking committee cut the federal funds rate, at which banks make overnight loans to each other, by a quarter percentage point, to 4.25 percent. The third rate cut this year is likely to trickle through to interest rates on credit cards, business loans and some adjustable-rate mortgages.

But investors had hoped for a half-point cut, or at least a clearer signal that the central bank will cut rates again, and stocks plummeted.

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